International Coordination of Financial Supervision Why Has It Grown? Will It Be Sustained?
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International Coordination of Financial Supervision Why has it grown? Will it be sustained? Richard J. Herring [email protected] Wharton School Managing Global Financial Risks: Shifting Sands and Shock Waves 22nd Annual Financial Markets Conference Federal Reserve Bank of Atlanta May 8, 2017 1 Overview Why has it grown? —Avoidance of negative externalities —Achieving positive externalities —Given these externalities what factors make cooperation more likely? How did these factors affect the growth of coordination in international banking? (Basel Committee) —In Securities Regulation and Supervision? (IOSCO) —In Insurance Supervision? (IAIS) The aftermath of the Crisis: G-20 & FSB Future of international supervisory cooperation? 2 What’s the motivation for international cooperation? 3 Motives Avoidance or mitigation of negative externalities —Generally after shock has occurred —Sometimes to avoid an anticipated shocks • Usually more difficult to reach consensus regarding events that may happen Attempts to achieve positive externalities —Generally less powerful • Often considerable uncertainty re: benefits vs. costs 4 Factors that facilitate cooperation International cooperation is more likely 1. The smaller the group of countries that must agree 2. The broader the international consensus on policy objectives and potential gains from cooperation 3. The deeper the international agreement on the probable consequence of policy alternatives 4. The stronger the international infrastructure for decision making 5. The greater the domestic influence of experts who share a common understanding of a problem & its solution 5 The Basel Committee on Banking Supervision Why cooperation began first & has been most ambitious in banking sector 1. Relatively small group of countries controlled 90% of cross-border banking activity 2. Keen awareness of the costs of failing to cooperate 3. Broad consensus on value of first steps 4. Could build on the infrastructure of the G-10 central bankers in Basel 5. Bank supervisors tend to share a world view and, until recently, have had considerable scope for exercising discretion 6 Huge international impact of the failure of a small German bank Establishment of Basel Committee on Banking Supervision 7 Bankhaus Herstatt 1974 8 Herstatt Lessons A very small bank with international operations can have a large impact on global markets —The largest FX market ceased functioning for more than a month —Several banks were cut off from the E$ interbank market Uncoordinated interventions by regulators can exacerbate market instability The option to control the timing of bankruptcy conveys substantial power Legal resolution took 35 years —Courts move slowly while markets move at the speed of light 9 The Basel Committee on Banking Supervision Initial challenge: how to cooperate? —Each foreign bank supervisor has at least two potential supervisory/regulatory authorities • Home country • Host country —What if they do not coordinate policies? • In worst case could stifle cross-border expansion • A policy decision in either country could cause problems in the other • Lapses in oversight home country could cause problems in the host country Answer: The Basel Concordat 10 The Concordat 1. No foreign banking establishment should escape supervision. 2. Supervision is the joint responsibility of host and parent authority. The host has primary responsibility for supervision of liquidity. The parent has primary responsibility for supervision of solvency. 3. Transfers of information between host and parent authorities should be facilitated. 4. Banks should be monitored on a consolidated basis for assessing risk exposures. 11 Continuing Challenges in Information Sharing Considerable progress in eliminating legal barriers But enormous reluctance to share bad news —Managers withhold from supervisors as long as possible —Primary supervisors withhold from domestic function supervisors as long as possible —Domestic supervisors withhold from foreign counterparts even longer Perverse incentives at every stage —Wishful thinking, hope problem self-correcting —Desire to avoid sanctions or loss of reputation —Concern over loss of discretion to deal with problem —Fear leak of bad news could cause run —Worry that foreign counterparts may have legal obligations that could result in actions that would exacerbate problem 12 Consolidated Supervision A sound approach if banks are free to move capital and liquidity from foreign offices where surplus to those with shortfall —In normal times, generally true —But in times of stress, the host country may ring fence Undoubtedly world financial system would be more efficient if could assume fungibility —But sovereigns cannot make a credible commitment to refrain from ring fencing Thus must meet standards on consolidated & stand alone basis 13 Banco Ambrosiano 1982 14 The Corporate Structure of Banco Ambrosiano Banco Ambrosiano (Italy) (68%) Banco Ambrosiano Holdings (Luxembourg) Banco Ambrosiano Banco Ambrosiano Overseas Ltd. Andino (Nassau) (Lima) 15 The Revised Concordat Greater emphasis on the principle of consolidated supervision New Points: If entity is not classified as a bank by host, then parent should either supervise or close. If host thinks parent supervision is inadequate, should either prohibit operations or place stringent conditions on operations. If parent is holding company, supervisors of separate banks should cooperate to supervise holding company. If holding company is a subsidiary, parent supervisor should supervise holding company and its subsidiaries or close. 16 Bank of Credit and Commerce International 1991 Mark Lombardi, 1951-2000, “BCC-ICCI,” Whitney Museum 17 Lessons 1. International banks can devise complex corporate structures that defy external oversight, much less consolidated supervision . BCCI managed to evade supervision 2. Although BoE urged cooperation to ensure no creditor would receive preferential treatment, a “single entity” or “universalist” approach — But several jurisdictions, most notably New York State applied a “separate entity” approach and ring-fenced the local operations — US also trumped all bankruptcy proceedings by instituting RICO proceedings against BCCI 3. Revealed profound international differences in institutional arrangements, objectives, and powers for dealing with an insolvent bank 18 Yet another revision of the Concordat Minimum standards for supervision of foreign banks Supervisory authorities have the right to gather information from the cross-border banking establishments for which they are the home-country supervisor. If a host-country authority determines home country supervisor not performing competent consolidated supervision can impose restrictive measures to satisfy its prudential concerns. U.S. Foreign Bank Supervision Enhancement Bank of 1991 19 Parallel Basel effort to harmonize supervisory frameworks & set minimum standards 20 Continuing efforts to encourage members to adopt common supervisory frameworks Began from astonishing divergence in concepts & procedures Reached consensus on —Core Principles for Banking Supervision Produced a series of papers identifying sound practices in various aspects of supervision Have become increasingly important —Serve as standards for FSAP evaluations by IMF/WB —Semiannual reports on completeness of adopted standards & gaps No enforcement powers —Moral suasion —Name and shame 21 Basel Accord on Capital Adequacy In response to shared perception that banks not adequate capitalized for risk they had taken on Individual countries frustrated when attempted to raise capital standards unilaterally Anglo-American Accord prodded Basel Committee to Act —Prudential objective —Level Playing Field objective Successive versions – Basel II & Basel III geometrically more complex 22 Barings, PLC 1995 23 Lessons 1. Revealed fragmentation in oversight — Among functional regulators in home country — Between home & host country authorities 2. Losses at Barings securities threatened exchanges on which it traded — Several firms threated to abandon membership in exchanges when loss-sharing arrangements clarified — Raised specter of contagion across derivatives exchanges 3. When losses discovered, BoE put Barings in Administration & stay imposed 4. Lack of segregation of customer funds both customers and counterparties lost access to funds because of bankruptcy stay — Liquidity in several markets dried up over the few days before ING bought Barings for￡1 24 The Windsor Declaration May1995 Supervisors of derivatives exchanges in 16 countries agreed to... —Cooperate in monitoring large exposures —Develop mechanisms to ensure protection of customer positions —Disclose procedures governing defaults —Establish an ‘on call’ schedule identifying a responsible regulator at each exchange IOSCO focus shifted from coordination of enforcement actions to cooperation in supervision 25 The disorderly failure that spurred G-20 to action 26 Lehman profile Asset size: $634 billion — 4th largest investment bank (more than twice as large as Bear Stearns) — 25,000 employees • Fewer than current compliance staff of Citigroup*Record earnings in 2007 — 150 years old — 6,000 legal entities in more than 40 countries Leverage (Debt/Equity) as high as 60:1 between reporting periods Main source of funding: O/N repos Extensive interconnections with the rest of the financial system — More than 1 million contracts outstanding at bankruptcy *Source: John Kay, “Complexity, not size, is the real danger in banking,”